Danish Mortgage-Credit Bonds during the Financial Turmoil

Carsten Andersen, Market Operations, and Claus Johansen, Financial Markets

INTRODUCTION AND SUMMARY

In many European countries, the financial turmoil in the autumn of 2008 meant that liquidity dried up in the markets for covered bonds. Sud denly it was neither possible nor attractive to issue bonds of this type, and nor was it possible to trade in bonds already issued.

The Danish mortgage-credit market was a notable exception. Com pared with most other European markets, it remained relatively liquid, and issuance still took place. One of the reasons is the large and stable domestic investor base. Moreover, in other countries covered bonds are merely one of a range of financing instruments.

As regards prices, Danish mortgage-credit bonds were, however, more severely hit by the financial turmoil than the corresponding German bonds. This is attributable to a combination of domestic sales pressures and foreign investors' sales of krone-denominated bonds because the Danish market was still liquid compared with other markets. The domes tic sales pressures were addressed by way of the Agreement on financial stability in the pension area (the "Pension Package")¹ in late October, but foreign ownership of Danish mortgage-credit bonds remains lower than before the financial turmoil in the autumn of 2008.

The steeper yield curve resulting from the low policy interest rates means that the vast majority of newly issued bonds are non-callable fixed-rate bullet bonds ("fixed bullets") used for financing adjustable-rate loans. Consequently, an increasing share of the Danish mortgage-credit market is made up of fixed bullets with annual refinancing, and the upcoming fixed bullet auctions in November and December 2009 will be the largest auctions to date.

COMPARISON OF THE DANISH MORTGAGE-CREDIT MARKET AND THE EUROPEAN MARKET FOR COVERED BONDS

In 2009, the increase in the outstanding volume in the Danish mortgage-credit market has come from fixed bullets. Since the introduction of adjustable-rate loans in 1996, these bonds have constituted an in creasing share of the overall mortgage-credit market. In contrast, the outstanding volume of callable fixed-rate bonds has been relatively stable, thereby accounting for a falling share of the total market, cf. Chart 1.

The combination of falling interest rates since mid-2008 and a rising share of fixed bullets in the Danish mortgage-credit market has reduced the average fixed-interest period, expressed as the duration in the mortgage-credit market, cf. Chart 2.

The European market for covered bonds has evolved from comprising only Germany (Pfandbriefe) and Denmark (mortgage-credit bonds) to now comprising more than 20 European countries.² Issuance in Europe is, however, concentrated on a few countries. Covered bonds in Ger many, Denmark, Spain and France thus accounted for around 81 per cent of the total outstanding volume in the EU at end-2008, cf. Chart 3.

At the end of 2008, the outstanding volume in Denmark constituted 160 per cent of the gross domestic product, GDP, while the equivalent figures for Germany and Spain were 32 and 30 per cent of GDP, respect ively.

Issuance volume during the financial turmoil
In the euro area, the financial turmoil reduced issuance of covered bonds in the form of jumbo issues³ substantially. In the 4th quarter of 2008, practically no bonds of this type were issued in the euro area. Con versely, mortgage-credit bonds were still issued in Denmark in the 4th quarter of 2008, and total issuance of Danish mortgage-credit bonds in the 2nd half of 2008 was only slightly lower than in the 2nd half of 2007, cf. Chart 4.

Since the 4th quarter of 2008, issuance of Danish mortgage-credit bonds has been concentrated on callable fixed-rate bonds and fixed bullets, cf. Chart 5.

There are several reasons why issuance continued in Denmark. Issuers did not switch to other types of issuance, such as government-guaran teed bank issuance or private placements, as was the case in other European countries.⁴Moreover, non-residents own only a small share of Danish mortgage-credit bonds, cf. Chart 6, and consequently the impact on demand was fairly limited when foreign investors withdrew from the Danish mortgage-credit market.

As in other countries, monetary-policy counterparties in Denmark have unlimited access to pledging mortgage-credit bonds as collateral for liquidity in Danmarks Nationalbank's open market operations, cf. below.

Members of the Danish Securities Dealers Association have established a voluntary market maker arrangement for trading among themselves in a number of mortgage-credit bonds. This arrangement has been sus pended since the 4th quarter of 2008, but nevertheless mortgage-credit bonds have still been traded, although the bid-ask spread has been higher than before the financial turmoil.

PLEDGING OF COLLATERAL TO DANMARKS NATIONALBANK

The financial turmoil in the autumn of 2008 led the monetary-policy counterparties to borrow substantial amounts from Danmarks Natio nalbank. Such lending is collateralised. Until early December 2008, more than half of the increase in collateral pledged was in the form of callable fixed-rate bonds and fixed bullets, cf. Chart 7.

Collateralised lending continued to rise throughout December 2008. The increase mainly reflected Danmarks Nationalbank's provision of loans in foreign currency, cf. the article Danmarks Nationalbank's Euro and Dollar Auctions, p. 47. The monetary-policy counterparties to a large extent chose to pledge fixed bullets as collateral.

Even though mortgage-credit bonds account for the vast majority of the collateral pledged to Danmarks Nationalbank, the bonds pledged constituted only some 13 per cent of the total volume in the market as at mid-2009. In 2009, fixed bullets have accounted for a still growing share of the collateral pledged to Danmarks Nationalbank. This increase exceeds the general increase in bonds of this type in the mortgage-credit market, cf. Chart 8.

The rising share of fixed bullets in the collateral pledged is presumably ascribable to various factors. Firstly, many monetary-policy counter parties place some of their short-term funds in these bonds, and sec ondly, financing such bonds by way of monetary-policy loans entails limited interest-rate risk.

THE FIXED BULLET AUCTIONS IN NOVEMBER AND DECEMBER 2009

The large issuance volume in fixed bullets in 2009 means that the upcoming fixed bullet auctions in November and December will be the largest to date. At end-August indications were that they would exceed the auctions in December 2008 by up to kr. 300 billion, cf. Chart 9.

The exact auction volumes will depend on the degree to which borrowers will continue to ask for adjustable-rate loans and the extent to which they decide to lock the rate of interest prior to the auctions.

In any case, bond sales will be highly concentrated and will potentially involve a considerable element of variation in the borrowers' interest costs.

DEVELOPMENT IN CREDIT SPREADS DURING THE FINANCIAL TURMOIL

The yield spread between mortgage-credit and government bonds in Denmark has typically mirrored the equivalent German spread closely, cf. Chart 10. To illustrate this, a Danish 5-per-cent callable mortgage-credit bond maturing in 2038 has been compared with a German jumbo issue with more or less the same duration as the Danish bond. For the Danish mortgage-credit bond, the option-adjusted yield spread is applied, thereby adjusting for the option element contained in the Danish bond, but not in the German bond. The excess yield on investment in a mortgage-credit bond compared with a government bond reflects the higher liquidity, credit and possible volatility risk linked to the former.

In the period from January 2007 to the end of September 2008, the correlation between the two yield spreads was 0.96. In October 2008 a decoupling of the two markets took place, and the correlation measured over the seven months from October 2008 to April 2009 became negative as the Danish yield spread widened substantially. This a attributable to a multitude of factors. Generally, the period in question saw sales pressure on Danish mortgage-credit bonds because investors sought to reduce their balance sheets and limit their credit risk. In addition, the financial turmoil meant that some investors were compelled to divest Danish mortgage-credit bonds.

The widening of the yield spread to government bonds was not a purely Danish phenomenon. It was seen, to a greater or lesser extent, in all European markets. In many markets, liquidity dried up following the widening of the spread. It was no longer possible to obtain keen prices or make large transactions in those markets. As previously stated, the Danish market maker arrangement for mortgage-credit bonds was sus pended. The same applied to equivalent market maker arrangements for covered bonds elsewhere in Europe.

In the same period, decoupling also took place between the mort gage-credit yield and the rate of interest applied for calculating the value of the future commitments of insurance and pension companies. As a consequence of the decoupling, mortgage-credit bonds could no longer hedge the commitments of insurance and pension companies to the same extent. This reduced the demand for mortgage-credit bonds and led to a risk that the insurance and pension sector would divest substantial volumes of mortgage-credit bonds.

At the end of October 2008, the Pension Package was concluded. Among other things, this agreement entails that the yield on mortgage-credit bonds is temporarily included in the yield curve used by pension companies to calculate their commitments. This had a very clear and immediate effect on the Danish mortgage-credit market. The spread between government and mortgage-credit bonds narrowed consider ably in the wake of the agreement.

At end-August 2009, the Danish credit spread was still on the wide side relative to the equivalent German spread, but it was in line with the French and Spanish credit spreads, cf. Chart 11. The particularly strong effect of the financial turmoil on Danish mortgage-credit prices thus seems to have abated.

LITERATURE

BIS (2007), The covered bond market, BIS Quarterly Review, September 2007.

ECB (2008), Covered Bonds in the EU Financial system.

European Covered Bond Council (2008), European Covered Bond Fact Book.

Jobst, Andreas, John Kiff and Carolyne Spackman (2009), The Covered Bond Squeeze Play, VoxEU.org.

Danish Ministry of Economic and Financial Affairs (2008), Agreement on financial stability in the pension area.